Producer Prices Contract: Is Deflation Catching Up With the Fed?

Inflation appears to have evaporated from the U.S. economy. On Friday, the Bureau of Labor Statistics reported that its seasonally adjusted producer price index for finished goods declined 0.1 percent in November, its third consecutive sequential contraction. The headline finished goods index is now up just 0.7 percent on the year, indicating that price pressures in the pipeline are weak at best.

The PPI interprets price changes from the perspective of the seller and can be used as a leading indicator of inflation because it measures input price pressure. While popular indexes of prices such as the Consumer Price Index and the Personal Consumptions Expenditures Price Index measure the change in prices that consumers pay for goods they buy, the PPI measures the change in prices that the sellers/retailers of those goods pay to wholesalers and producers.

The producer price index report is broken down into three broad sections: crude goods, intermediate goods, and finished goods. The finished goods component is closest to the consumer, and the crude goods component is farthest away. Price increases at any stage of production can sometimes be passed down the line and could ultimately reach the consumer, as reflected in CPI and the PCEPI.

With this in mind, it’s clear that there are no meaningful price pressures at the producer level that could make their way to consumers. Falling energy prices have been the primary downward pressure on overall prices, contracting 0.4 percent in November. Food prices at the producer level were flat on the month. The core PPI, which factors out food and energy prices, increased 0.1 percent on the month.

Moving down the pipeline, the price index for intermediate goods — or the stage of processing index, which represents ready-to-use materials like steel and lumber — fell 0.5 percent on the month in November, which follows a 0.4 percent decline in October. Energy also accounted for most of the decline in prices at this point in the pipeline, falling 1.5 percent.

The price index for crude goods fell 2.6 percent on the month in November, with the index for crude energy materials falling 6.6 percent. Most of this price change in turn can be attributed to an 11.7 percent decline in the price index for crude petroleum.

Investors have kept inflation data in their periphery recently because of the Federal Reserve’s aggressive stimulus program. Quantitative easing — the name given to the Fed’s ongoing purchases of agency mortgage-backed securities and longer-term Treasury securities — has four primary effects on the economy: higher inflation expectations, currency depreciation, higher equity valuations, and lower real interest rates.

The intended consequence is to spur spending in interest rate sensitive sectors, which, as Fed Vice Chair Janet Yellen articulated in her recent testimony before the Senate Banking Committee, should “stimulate a favorable dynamic in which jobs are created, incomes rise, more spending takes place.”

Along with its impact on interest rates, quantitative easing drives down currency valuations, which impacts imports and exports; increases inflation expectations; and increases equity valuations. Quantitative easing impacts pretty much every corner of the financial market, which means that any changes to the program will also impact pretty much every corner of the financial market.

Most of these effects have manifested in the United States to some degree, but inflation data released over the past few months have struggled to remain positive. James Bullard, president of the Federal Reserve Bank of St. Louis, said in a recent presentation to the CFA Society in St. Louis that inflation “continues to surprise to the downside,” continually running below the Fed’s 2 percent inflation target and foiling the central bank’s expectations that inflation is trending toward the 2 percent level.